China consumer goods

Spilt milk in China

September 9th 2014 | China | Food and drink | Multiple companies

A handful of champions have emerged from China's latest regulatory shake-up of the infant formula sector.

Anyone who has crossed the land border between mainland China and Hong Kong lately knows the penalty for being caught with too much powdered infant formula. Travellers crossing into the mainland are allowed only two tins—or 1.8 kg—of powder each, and transgressors could face a hefty fine and two years in jail, according to giant posters on the Hong Kong side.

The penalties target smugglers buying up supply in pharmacies in Hong Kong which sell at retail prices that are up to 50% lower than the mainland. The crackdown on the border smuggling (where police routinely search anyone with bulky luggage) is part of a regulatory shake-up in Beijing, which is seeking to reassert local control over the booming dairy industry—and especially profitable niches like infant formula.

Infant formula is one of the fastest growing dairy market segments in the world, with global sales up US$4bn in 2013. This is in large part due to China, where demand is expected to grow by 21% this year to total Rmb91bn (US$14.56bn,) according to projections from Rabobank. The melamine scandal of 2008 has allowed importers to expand their market share from 30% to 50% and imports rose by another 24% in the first quarter of 2014 (1m tons were imported in 2013).

Changing faces

But the key importers are changing as China seeks to regain control of the industry through new regulations that require registration with China's quarantine body: the General Administration of Quality Supervision, Inspection and Quarantine (AQSIQ), which since May has also required Chinese language labelling affixed at source on any imported formula. This is leading to a consolidation among importers, indeed a third of smaller foreign suppliers have already left the market rather than complete the complex licensing and labelling process.

Beijing wants to rebuild a handful of key domestic brands which took processing offshore to rebuild their reputations after the melamine scandal which resulted in six infant deaths and 54,000 hospitalisations. As such it hopes to see the industry consolidate to ten big milk powder companies with over Rmb2bn in annual revenues. By 2018 it hopes that this number will have halved again and a US$5.6bn M&A government fund (in low-interest loans) is available to large-scale domestic dairy firms who want to make acquisitions.

The industry will likely consolidate around a handful of brands, with locals continuing to sell imported product under their own names. These include key local player the Yili Group which processes 50,000 tons per year in New Zealand (one-third of its total output) and sells "100% imported" 900g tins for Rmb298 in Beijing supermarkets.

Visits to Beijing supermarkets suggest that the clear winners already appear to be a cluster of companies with diversified supply chains, ensuring that if China's inspectors find a problem with product from one country there will be of others to source from. In terms of shelf space the clear winner is Swiss-based Nestle, which imports milk powder to China from subsidiaries in Europe, Australia and New Zealand. Likewise, French firm Danone imports from across the EU and New Zealand. Another ubiquitous presence is Wyeth, which sources and manufactures in half a dozen countries for its 'SMA Gold' product range. There's also Mead Johnson's Enfapro and Enfamil brands. Investors are drawn by China's long-term demand for milk, with consumption expected to rise quickly in the coming decades.

Supply issues

China's domestic output is not keeping up with demand. Local production of dairy (of all categories) will go from 48m tons in 2014 to 58m tons in 2022, according to the UN-run Food and Agricultural Organisation (FAO), with average growth of 2.4% per year compared to the average 6.9% average annual increase in output in the previous decade. This presents strong opportunity for a handful of key infant dairy powder producers (and the countries where they source). Tight global supply and a spike in Chinese demand led to international dairy prices hitting record highs in April, points out Dr Grainne Redmond, a dairy analyst at the Irish Food Board. The Chinese milk powder market alone is valued at Rmb100bn a year by leading French-based dairy firm Lactalis. China's total dairy consumption will post a 13% annual increase in up to 2020 with 20% average annual growth at the 'premium' end – in products such as infant powder and cheeses - according to Australian bank Macquarie.

Cautious investment

Given calamitous dairy scandals, foreign dairy companies are privately very wary about investing in China without a controlling stake in the operation. Unsurprisingly New Zealand's dairy giant Fonterra chose recently to team with multinational pharma giant Abbott rather than domestic firms in a US$300m joint venture which will produce infant formula using imported milk but also ultimately milk from Fonterra's farms in Hebei and Shanxi provinces.

Domestic efficiency has a way to go considering Chinese cows are currently producing maximum seven tons of milk per cow a year whereas the comparable figure in the EU is 12 tons, according to World Dairy Council data. Indeed Chinese dairy output slipped 5.7% year on year in 2013 to 35.5m tons, causing prices to rise as producers battled for supply. Investors are also drawn to dairy in China because it's profitable: leading local player Yili recorded an 84% year on year rise in profits in 2013 to Rmb3.2bn, on revenues of Rmb47.7bn. Its key rival Mengniu made Rmb1.6bn profit from Rmb43.3bn revenues.

The future looks bright for well-resourced companies like Nestle—and Yili on the Chinese side, whose move to acquiring powder processing capacity overseas looks set to be repeated by other Chinese players emerging from the ongoing consolidation process. Firms relying on local resources look likely to struggle. Aside from safety issues China doesn't appear to have the resources to meet its own dairy needs. Multinationals have publicly been encouraged by Chinese officials to team up with local champions. A European dairy executive (who imports rather than produces here) questioned the wisdom of investing in local dairy production, which is becoming pricier thanks to shortages of fodder, land and veterinary expertise.